...against fictions and other tall tales

Saturday, 21 April 2012

A microeconomic perspective on the “loans create deposits” meme

By Joseph Laliberté

A private bank’s “cash and cash equivalent” position as shown on its balance sheet typically includes its deposits with other banks, excess reserves at the central bank and vault cash.  In financial accounting, the cash flow statement illustrates the main elements impacting the cash and cash equivalent position of a business between the beginning and the end of a given period.

Perhaps one of the most fascinating aspect concerning the obsession of mainstream macro economists with banks’ cash and cash equivalent position (excess reserves, in particular) is the near irrelevant status this component has in banking and financial circles.  Below is an extract from a letter of the German Banks Association (Bankenverband) to the International Accounting Standards Board (IASB) that illustrates perfectly the lack of interest that many have in regard to banks’ cash position:
One of the major objectives of the boards' proposals is to provide information which is relevant to predicting future cash flows.  We agree that the issue of liquidity presents a significant challenge for the banking sector.  Nevertheless, cash flow statements cannot help to assess future liquidity in any way.  No financial analyst, for example, has ever queried any of our member banks about, or given any great consideration to, the cash flow statement.  If the IASB has information pointing in another direction, we would be interested in the details. (emphasis added)
Illustrative of the non-importance of a bank’s cash flow statement is that the very definition of “cash and cash equivalent” used for the purpose of building the cash flow statement appears far from standardized across the banking industry.  Some banks, such as Deutche Bank, divide “cash and cash equivalent” on the asset side of its balance sheet into “cash and due from banks” and “interest-earning deposits with banks”. However, for the purpose of its cash flow statement, Deutche Bank defines “cash and cash equivalent” as “cash and due from banks” PLUS “interest earning deposits with banks” MINUS “term deposits with banks”.  For its part, the French bank Société Générale presents on the asset side of its balance sheet two categories (i.e., “cash, due from central banks” and “due from banks”) while for the purpose of its cash flow statement it defines "cash and cash equivalent" as follows: (“cash, due from central banks” MINUS “due to central banks”) PLUS (“due from banks” MINUS “due to banks”).  Closer to home, ScotiaBank defines “cash and cash equivalent” as “cash and non-interest-bearing deposits with banks”, thereby excluding interest-bearing deposits with banks, while National Bank includes cash and all deposits with financial institutions.  Go figure!  One would assume that banks would find it necessary to settle on a common definition of “cash and cash equivalent”, especially since we are often told by the financial press and many economists that this asset component is so critical in analyzing banks’ capacity to extend loans.

That said, even if all banks would settle on a common definition of “cash and cash equivalent”, this asset category would still say very little about a bank’s liquidity.  The reason for this is that any given bank could have a cash and cash equivalent position of zero and still be considered highly liquid thanks to its holding of cash management bills/T-Bills/government bonds. 

Furthermore, the cash and cash equivalent position says nothing about a bank’s capital ratio, the critical element in determining a bank’s capacity to extend credit.  Banks’ capital is allocated to balance sheet expansion through loan and deposit creation, not banks’ cash or reserve position.  As per the cash flow statement of a deposit-taking institution, net additional loans to customers are considered a use of funds, and net additional deposits from customers are a source of funds.  Therefore, once a loan is granted and the customer’s checking account is marked up by the same amount, the cash and cash equivalent position of the bank is left unchanged.  From a microeconomic banking perspective, loans create their own source of funds, or stated differently, "loans create deposits".  Assets-liabilities duration mismatch (interest rate risk) is of course an important consideration, and this is where the discussion ties in with the central bank’s decision on interest rate.

One last point that deserves to be highlighted is that, although a bank’s "cash and cash equivalent" position generally says nothing about its capital position and, consequently, its regulated lending capability, an increase in this asset item may sometimes reflect improved liquidity.  This was arguably the case with QE1 when the Fed purchased mortgage-backed securities (MBS) by crediting private banks’ reserve account at the Fed.  Moreover, if one assumes that with QE1 the Fed engaged in fiscal policy by overpaying for MBS (relative to their market value), then it could be argued that QE1 may have also helped to improve banks’ capital position as well as their regulated lending capability.

In the case of Canada, a QE1 style program was put in place, but since reserves were “mopped up” with the issuance of Canadian government bonds, there was no impact on banks’ “cash and cash equivalent” position, a situation that led to an improvement in their liquidity position (as it did in the U.S).  As for the matter of bank capital, contrary to the U.S., there was no direct injection of public funds to recapitalize the banking sector in Canada.  However, just like what happened in other jurisdictions, accounting authorities proved accommodative.  Changes to the Canadian Institute of Chartered Accountants Handbook in October 2008 allowed banks to re-classify financial assets from “held-for-trading” to “held-to-maturity” under specific circumstances.  Use of this re-classification put some banks on stronger regulated capital footing than would have been the case otherwise.

The FRB blog invites your comments. Please share your thoughts below.


  1. An excellent synopsis as usual,JL

  2. An interesting post for its multifacets.

    Reads in parts like Sherlock Holmes trying to snare Carmen Sandiego. Good luck with the effort.

    1. Joseph Laliberté28 April 2012 at 08:06

      Thanks B.Swells,
      Beside poetry, I also enjoy reading corporate annual reports & financial statements. I have long been familiar with industrial companies annual reporting. Only recently did I discovered the fascinating world of banks' financial statements.

    2. @swells: I agree that JL's article is multifaceted, and very interesting!!

      I guess that I don't follow the Holmes/Sandiego insertion. Since I'm not as familiar with poetry as JL, and probably not as familiar with Corporate Reports and F/S as JL, I'd welcome the clarification of the Holmes/Sandiego insertion.

  3. On my end, I've been reading lots of fiction these days. That's what the literature in support of (or that denies the problems with) austerity really is: pure fiction. If only it rhymed like poetry, it would be of some value.

  4. I always find FRB articles refreshing because they are not iconoclastic, notwithstanding being reverently critical-features most other economic posts lack.
    @JL: I also have poets in my immediate environment.!
    @Circuit. Austerity's literature is a 'dismal science'!
    @kp: Actually, my comment was a compliment. I was being allegorical of course: Holmes is FRB and Sandiego …but let's drop the allegory. I apologize if I sounded facetious.
    @FRB: Clarifying concepts for the sake of taxonomy is fine, or setting up a snare, and snaring a fraud is satisfying (lol) but it's more pragmatic for FRB to elucidate its position on the role of monetary policy and fiscal policy, the role, if any, of central banks, within this context and the role of Banks, if any, within the micro/macrosystems. I am not pushing anyone in taking positions on dynamics vs equilibrium, I/S ; PED or any other traditional topic.
    -MMT places great importance, and fairly (not solely) on the Money and Banking paradigms as resolute actors and agents within the economic setting. Those entities are, in marxist ref, the infrastructure of the modern financial system (some theoreticians (?) contend the system needs no Banks: verticalists vs horizontalists) -displacing labor in a political democracy.
    -Loans are generated by effective demand and to some extent effective demand is exogenous (let's avoid the rubbish on whether it is or isn't) to the banking system. What MMT fails to emphasize in its choppy rhetoric of 'Bank and Money' is the fundamental keynesian/kaleckian premise that bank loans should not be created unless there is such demand in the system. Effective (aggregate for some others' sake)demand activates economies, and the banking system responds thereto the measure of demand. Put aside the displacement of labor. The idea that loans will engender demand is only credible if the entrepreneur and/or consumer triggering the demand is not susceptible to consequential damages in assuming risk. Hayek's thesis that the system inheres unintended consequences is precluded from this model. Any other entailment resurrects supply macroeconomic dilemmas.
    -One of the advertized pop features of MMT is that a sovereign currency issuer can't go under. More interesting, and less advertized, although FRB has flirted with it, is the systemic entailment: a banking system can theoretically be kept solvent by its Central Bank (of course, constitutionally subrogate to fiscal consent). In fact that's what the Fed did periodically since 2007 through the extension of credit-the lore is now common wisdom. Bear Stearns was a case of dissipating damage, but Lehman's insolvency involved a decision by US fiscal authorities not to establish precedents in the matter of systematic systemic bailouts. For many reasons, most unrecorded, Lehman was let go, and the intended signal sent to the world's financial markets and players.
    -I would have enjoyed Circuit and JL to have followed through on one facet of the thread: since cash and cash equivalents seem to be of minor significance to the solvency of a bank, then what is: bad loans? Can there be bad loans, in extremis insolvency, under a strict MMT regime or whatever variant, when the monetary jurisdiction oversees a sovereign currency. That is one legitimate microeconomic policy worth debating: systemic bank defaults. If theoretically not, then should 'bailouts' be constitutionally sponsored. Individuals? The answer is in the article, I assume, but not explicit.
    -I for one think the column is on a spectacularly interesting roll and would welcome knowing FRB's position on some of the above. I am certain that many readers would like FRB to give its coordinates and directions in that seascape. If I missed it, I can blame the cuckoo clock for not being a diligent mechanism.

    1. Joseph Laliberté1 May 2012 at 15:46

      Thanks for your comment. You bring lots of good points. Before responding to some of them, let me say that I have been focussing (mostly) on the mechanics of the modern money (banking) system so far, and I have (mostly) refrained from advancing policy proposals. Policy proposal is the finality, but much of the leg work actually takes place prior to formulating policy proposals. I take a pragmatic view of the policy formulation process:
      1.what are we trying to accomplish? Basically, what are the key policy variables we are trying to optimise and what are the constraints? (e.g. optimising economic growth and stability, employment, price stability, equal opportunity, income equality, happiness, etc subject to labour, ressources, environment constraints ...etc)
      2.what do we have now? (this includes a hard nose understanding of how the current system/institutions work, and the policies and regulations in place)
      3.What are the problems with our current system? How could it be improved to better achieve what is described in 1).
      4.Formulating new policy proposals based on 1), 2) and 3).

      I find that we are all guilty at times of jumping to 4) a bit too fast, that is, before doing due diligence.

      With respect to fiscal vs monetary policy, I clearly think that the use of monetary policy is not optimal in regulating economic growth and ensuring price stability, and that fiscal policy would be a far better tool. Fiscal policy, being a political process, has however many political impediments of its own, and this may explain why we came to rely on a combination of monetary policy and fiscal policy (automatic stabiliser + ad hoc fiscal initiative) to promote/stabilise economic growth and achieve price stability. MMT understands this well, and has put forward a job guarantee proposal which, as I see it, is an attempt to improve and build on the current automatic stabilisers we have in place, thereby enhancing the fiscal component response. While understanding the policy objective, and understanding that fiscal is a more effective policy tool, I still have my doubts at this point on the job guarantee proposal.

      On the issue of bank supervision, this is not an easy one either. Right now, a private banks’ IOU is to a large extent a State IOU (either officially through deposits insurance, or de facto in the context of “too big too fail”). In this context, the bail out is constitutionally sponsored whether we like it or not as the horizontal players (banks) are vested with the power to create State IOUs. This is amazing when you think about it: the State willingly shares its monopoly power with the private banking sector when it comes to creating State liability. Without the ability to create State IOUs, banks’ liability would just be just that… private liability. The State being center stage in the horizontal process is a matter of operational reality. Warren Mosler says banks’ liability is not the place for market discipline, and this is why I think he would call banks private/public partnerships that are established with the public purpose of providing loans based on risk/return analysis. Implicit in this (I think), is that private banks are better able to do credit analysis than the State would. That is, the asset side of the banking sector is best left to market discipline, than to State discipline. This dichotomy between the asset side and the liability side of a private bank should make state supervision and regulation of banks a no brainer. Sadly, the debate is rarely framed this way.

      In any case, stay tune, more posts to come on all these issues.

  5. @JL i'm not sure BoC's 'twist' is MB. not in their ops for what you insinuate, although they do get subtle. hey, times change, maybe they're being influenced. na! good posts FRB.

    1. Joseph Laliberté1 May 2012 at 15:51

      thanks for your comment. I should have specified that outright purchase of mortgage backed securities was accomplished by Canada Housing and Mortgage Corporation, not the Bank of Canada.

  6. Swells, you must be reading my mail. Good comments! The issues you raise are central. Indeed, once we get passed the operational details, it's clear that the regulatory aspect is key. I also would enjoy a good discussion on these points. I agree that JL's piece provides a good segueway.

    On the issue of bad loans, there is no question in my mind that financial crises are primarily caused by banks extending bad loans. But this seems to be too simple for both the expert and the lay person. Yet, astute observers such as John Wood tend to agree that the principal cause of financial crises are bad loans (although Wood places more emphasis on the impact of negative real rates than I do). Regulators and bankers can claim that it's really about mathematical/economic models, technology, global imbalances, easy money, etc, but in the end, it is banks that are the ones who are responsible for ensuring that valuation and risk assessment is properly conducted. As the BoC correctly reminds us: "financial institutions are responsible for appropriately assessing risk, as well as the ability of clients to service their debts".

    As to whether the government ought to bail out banks during crises to preserve stability, I am of the view that this does not promote the right incentives. The proper course of action, even under a sovereign currency issuer, would be to set strong penalties against suboptimal practices that jeopardize the system. Although I don't speak for them, I believe most MMT economists would agree that banks should not be rescued blindly. Indeed, pension benefits would be guaranteed via the pension benefit guarantee corporation. But that's about it. As Randy Wray puts it, there is currently "too much money chasing too few good investment". With failures offset by greater public sector investment, the system would endure.

    Since you brought it up (again, I'm glad you did), I'm curious to know your take on this. I realize there are problems from a pragmatic standpoint. Do you see any insurmountable challenges with the overall MMT view? In applying it, that is.

    Finally, as for poetry and economics, I would argue that these make for an excellent combo. As references, I suggest Boulding ('58) and Copeland ('52), both of which are classics of circuit theory.

  7. @circuit & JL: I have no concerns regarding either your intentions or approaches!!! It's refreshing to be transported to a previous era when all when was evolving. To say the least, to be reminded that Boulding was a poet besides being a great economist (nod to Wray!! on that optic) and thinker, and that Copeland pioneered the money flow operatives back in the '50s is remarkable in blog space. My only caution is that one not forget Mitchell when referring to Copeland. The latter was himself a remarkable thinker-a very inspiring historian, and retain that Boulding was also a religiously devout person which should inspire some of the pop economists around when dealing with the consequences of austerity. Stay the course.

    Do you need a Central Banker separate from a Treasury?

    I contend you do. I am not cynical/facetious when I suggest that Governments are transitional structures, and inter-jurisdictional relationships, especially financial relationships are far more enduring. In a global economy, one needs co-operation and continuous transparency and communication. In a non-homogeneous financial system, one needs an even more pervasive understanding of the trade-offs between sovereigns. Global finance is highly in-bred and symbiotic in nature. Apart from issues such as price stability which steered the ECB until Draghi realized the specific undertoe was lethal, Job Guarantees which is bad weather for any knowledgeable captain without private sector participation (as one of your readers insisted on a while back), the division between monetary policy and fiscal policy must be respected in order to ensure that the democratic process pursue the common good beyond the timelines of party politics.

    I'm not asking anyone to attempt surfing Jaws, but GC summarized it well in FRB's August post: "Some models contend that MMT needs no central monetary authority (let’s forget government for now); in fact, others contend that it doesn’t need banks and/or money and lest one forget, the manner of equilibrating the real rate of interest under certain conditions is still up in the air. However, in the ‘real world’ which is neither a model nor a homogeneous system, there are risks, demand for credit; disparities, inequalities, uncertainties among and within economic sectors: manufacturers, labour, retailers and purchasers, service providers, and the financials. As to the latter, there are definitely differences between Wall Street banks (macros units) and smaller regional banks (micro units) etc.

    Who accommodates and channels (types) the monetary policy and how, etc. How does one (who) manage..."

    Let's acknowledge that income distribution (employment), commensurate with aggregate demand, with price stability a second, is the underlying catalyst of keynesian pragmatism, Do you optimize an economy with or without a credible backstop. Treasury is not a credible backstop unless one redefines the constitutional status of certain executive roles. For stabilizers to be effective, they have to have a de jure life beyond the life span of an elected government.

    The question of Backstops may not be fair; but the battle of European hearts and minds is exactly about that. Austerity is about pleasing investor demands with respect to confidence in the respective banking system to service its debt in a timely manner. It's about 'How do I get my money back more securely than before this mess?"

    To deny the structural role of a central bank is challenging both fiscally and politically for any MMT regime.

    1. keynespendulum7 May 2012 at 08:22

      @swells: I always enjoy your inputs. Most of the time, the anecdotes are worth a book-and-a-half. Keep supplying them. I'm interested in the emphasis you and GC place on the 'structural role' of the Central Bank. Perhaps it's the notion of a 'structural role' that puzzles me.

  8. @kp. The financial system we inhere is heterogenous. Besides a multitude of currencies and products, the operatives behind the exchange system reflect a broad range of goals and expectations. Nevertheless, one can assume that investors in general, pre-empting ethical concerns, cherish an expectation that whatever currency they signed on, it should remain reasonably stable throughout the term of the investment and will not have depreciated in value unnecessarily or unexpectedly. This trust, of course, presumes the trivial-that the debtor is still afloat.

    Both wishes, stability over time and liquidity for repayment, are perceived to be much more easily enforced if an institution exists within the currency's jurisdiction that monitors both inflation and liquidities. In this sense, a Central Bank, is an inherent functionality. The identity of the global system is marked by Central Monetary Authority status, independent of government, and role in adapting to the dynamics of the financial system. Besides possessing a constitutionally defined status which itself predicates rights and privileges over time, the Central Bank's role is maintain credibility in the jurisdiction's ability to transcend, as best it can, the political realities which affects the currency, and bring a sense of real comfort and caution to the investment communities. In this sense, the Central Bank plays a structural role. It's basically a pillar of the system that defines the jurisdiction, the features of the currency and the identity of the debtor.

  9. Here is how the banker's game works:


    mansoor h. khan

  10. Swells, thanks for the detailed clarification. I admit that I first interpreted your use of the qualifier 'structural' to mean 'non-political' or 'independent', as in relation to the textbook role of CBs in the formulation of policy (long run and short run phases, etc). As for the "jurisdiction's ability to transcend the political realities which affects the currency", this one aspect that critics of central bank independence often forget. Myself, I'm generally skeptical of central bank independence but I agree that stability in this regard is of benefit to the system.

    Also, I agree with your take on Wesley Mitchell. Copeland's work on the flow of funds relied immensely on Mitchell's pathbreaking work stressing the importance of examining the financial accounts of the different sectors of the economy for understanding business cycles and stability. I was just citing M. Copeland in reference to his 'rendition' of the tale of the Walrus and the Carpenter.

  11. keynespendulum13 May 2012 at 20:31

    @swells. Thank you very much for your comment. I take your position as being very pragmatic and I concur with your view that CB's are 'structural' or foundational, in that sense, to the system. However I noticed that you excluded mention that in fact CB's must necessarily, at some point, get a nod from Treasury or Govt.

    Am I missing something.

    1. I assume incorrectly that my thread is seamless,l but it isn't and the time interval is sometimes lengthy. I do not position the CB over Treasury or para-entity. The former is appointed, the latter is usually elected or ensues in some format therefrom (eg Canada, UK...). Under normal conditions the roles of each are exclusive, and Treasury's status, at least in the US, should be primordial. Certainly, it is foremost in jurisdictional space, and constitutionally structures the operating basis of the Central Bank. On the other hand, this priority of Treasury is not tantamount to a ranking vis-a-vis the Central Bank. Within the democratic system, the check/balance imperative sustains, through market expectation, an independence of the Central Bank commensurate with its accountability.

      Elected government ultimately, in extremis, dictates policy for the elected. Other government systems may diverge in their prerogatives towards their Central Bank operations.

      Thankfully we are not there.

    2. Not to interject, circuit's reference to Copeland's fable of W&C is really about the mechanism of institutions in moneyflow economics. It predates Minsky's concern with inherently unstable institutions in a capitalist system. Of course, the main concern for Mitchell, Copeland and on a broader scale Minsky's critique of institutional capitalism is really a critique of the most essential institution of capitalism-money! In this context, structuring the necessary regulatory parameters requires institutionalizing the exchange mechanism itself. Hence one finds the development of the Federal Reserve (Central Bank) which promotes asset value stability and inhibits debt deflationary consequences.

      Somewhat simplistic but accurate.

    3. Oops...left out the all-important qualifier: 'decentralized capitalism'. Of course, all the above were excellent institutionalists.

  12. Thanks for the time you're all taking. Great stuff.

  13. Just to expand on my comment regarding central bank independence, I should mention that I'm actually supportive of the idea. Who isn't in favor of expertise over politics when it comes to complex and technical matters (although I realize that econ policy is not solely 'technical', i.e., as in the Greek conception of 'techne' devoid of moral considerations)? Where I am skeptical is when we equate the concept of 'independence' as simply being 'arm's length from elected government'. Ideally, I support true CB independence, as defined as impartial to the influence of special interests other than those resultant from the outcome of democratic governance. Here I agree with Swells that democratic checks and balances play a critical role in promoting (and sustaining) such independence. But does this independence exist? Bill Vickrey wrote that monetary authorities appear to be afflicted with an inherent "constitutional bias" resulting from their close association with financial interests and their "remoteness from the grim realities of unemployment". I used to think this was indeed the case. However, I've been pleasantly surprised by the chorus of sensible voices coming out of CBs these last few years. Maybe my views are changing on this point. Or maybe it's reverse causality and these guys are reading high quality commentaries (including FRB)! Anyway, all that to say that Bernanke, King and Carney are doing a better job than the elected officials these days. This is definitely one argument in support of CB independence. Let's just hope it continues.

    KP: thanks for asking the questions. These comments are great.

    GC: "Somewhat simplistic but accurate" refers to the W&C? Also, I take it there are no 'too big to fail' banks under decentralized capitalism?

  14. GC, in regard to my question above, I would agree that, as far as basic description, the W&C is accurate. It has the added value of saving the reader interested in the function of money time and effort.

  15. @circuit. Simplistic but accurate refers to moneyflows, and W&C reflects it appropriately as far as the purpose of the verses. Without reservation, the better Central Bankers, and there are many more now than there used to be in Volcker's time, are definitely attuned to political realities and the structural weaknesses in financial markets. Messrs Bernanke, King and Carney have all slipped in their day, in one form or another. Most recently, Mr. King admitted that his Cassandrian narrative was not loud enough; I suggest it was somewhat late. Mr. Bernanke shied away from the ominous signals in 2007, but has performed exceptionally since, and Mr. Carney may have waned his pre/post budgetimage slightly- Mr. Harper would have listened to a courageous voice, but Mr. Carney's tacitness was unfortunately misinterpreted. Nichigin's last five have been great executives, leading under highly political circumstances but Mr. Shirakawa will rank among the best in the world, so too his organization! As to Mr Zhou Xiaochuan from PBC: (which is a publicly-owned bank in passing) his challenges are of a different order and hence more complex to define and resolve. Nonetheless, PBC has navigated difficult lanes against strong headwinds, as a colleague would say.

    Nothing is too big to fail! but it's critical to assess what merits sustenance and what merits abstinence. Pragmatism is a fine divide: the difference between a squall and a storm is sometimes minimal, but the difference can damage a great ship. Independence is an accountable value, and obliges great transparency. The independence issue is highlighted by studying the BoJ challenges. This, I gather, is swells' point-a fine point.

    FRB is a very attentive narrative, and seems to be affirming itself as a master narrative. It's significant that the body of thought which consummates the many optics designed therein voice the merit of great thinkers and not tinkerers, as a reader of yours once dared.

    To list Keynes, Galbraith, Boulding, Vickrey as working shelves is a challenge and feat in itself. They are brilliantly Master Rebels.

    Stay the course.

  16. Master Rebels indeed. Who is it that said that anyone with the letter "K" in their name is to be taken seriously? Kalecki, Khan...and the list goes on. Your views on the CBs will anchor my assessments/commentaries moving forward. Grazie.

    1. keynespendulum17 May 2012 at 22:37

      Circuit, to correct the glitch... I take it you mean Richard Kahn, (not Khan) the originator of the income multiplier! I agree with agree with Kahn!

      @GC great insert. Just to return to your list of Master Rebels: would you include Mr. Volcker?

  17. KP: Yes, I meant to write Kahn. Thanks for the fix. As for Volcker, I think his general attitude toward regulation is sound. One aspect of his approach is that he understands the need for regulations to be simple -- both for the sake of regulators and regulatee. The problem, in my view, is when financial regulation is too complicated to understand or overly technical. Volcker appreciates that less is more in this area. It also makes the work of DOJ litigators that much easier (but that's another issue).

  18. Just to clarify: "less is more in this area" refers to complexity in regulatory frameworks and language. Obviously, it's not meant as promotion of deregulation or self-supervision (read self-delusion).